# CHAPTER 08 - PHALL-82241 PINDYCK CHAPTER 08 page 4 of 22...

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Unformatted text preview: PHALL-82241 PINDYCK CHAPTER 08 page 4 of 22 FIGURE 8.1 Profit Maximization in the Short Run Cost, revenue, profit (dollars per year) C(q) R(q) A B 0 q0 q* q1 π (q) Output (units per year) A firm chooses output q*, so that profit, the difference AB between revenue R and cost C, is maximized. At that output, marginal revenue (the slope of the revenue curve) is equal to marginal cost (the slope of the cost curve). Fig 08-01.EPS PHALL-82241 PINDYCK CHAPTER 08 page 5 of 22 FIGURE 8.2 Demand Curve Faced by a Competitive Firm Price (dollars per bushel) Firm Price (dollars per bushel) d \$4 Industry \$4 D 100 (a) 200 100 q Output (bushels) (b) Q Output (millions of bushels) A competitive firm supplies only a small portion of the total output of all the firms in an industry. Therefore, the firm takes the market price of the product as given, choosing its output on the assumption that the price will be unaffected by the output choice. In (a) the demand curve facing the firm is perfectly elastic, even though the market demand curve in (b) is downward sloping. Fig 08-02.EPS PHALL-82241 PINDYCK CHAPTER 08 page 6 of 22 FIGURE 8.3 A Competitive Firm Making a Positive Profit Price (dollars per unit) MC 60 50 40 Lost profit for q1 < q* D Lost profit for q2 > q * A AR = MR = P ATC C AVC B 30 20 10 0 1 q0 2 3 4 5 6 7 8 9 q1 q* q2 10 11 Output In the short run, the competitive firm maximizes its profit by choosing an output q* at which its marginal cost MC is equal to the price P (or marginal revenue MR) of its product. The profit of the firm is measured by the rectangle ABCD. Any change in output, whether lower at q1 or higher at q2, will lead to lower profit. Fig 08-03.EPS PHALL-82241 PINDYCK CHAPTER 08 page 7 of 22 FIGURE 8.4 A Competitive Firm Incurring Losses Price (dollars per unit of output) C D MC ATC B P = MR A AVC F E q* A competitive firm should shut down if price is below AVC. The firm may produce in the short run if price is greater than average variable cost. Fig 08-04.EPS Output PHALL-82241 PINDYCK CHAPTER 08 page 8 of 22 FIGURE 8.5 The Short-Run Output of an Aluminum Smelting Plant Cost (dollars per ton) MC 1400 P2 1300 P1 1200 1140 1100 0 300 600 900 Output (tons per day) In the short run, the plant should produce 600 tons per day if price is above \$1140 per ton but less than \$1300 per ton. If price is greater than \$1300 per ton, it should run an overtime shift and produce 900 tons per day. If price drops below \$1140 per ton, the firm should stop producing, but it should probably stay in business because the price may rise in the future. Fig 08-05.EPS PHALL-82241 PINDYCK CHAPTER 08 page 9 of 22 FIGURE 8.6 The Short-Run Supply Curve for a Competitive Firm Price (dollars per unit) MC P2 AC AVC P1 P = AVC 0 q1 In the short run, the firm chooses its output so that marginal cost MC is equal to price as long as the firm covers its average variable cost. The short-run supply curve is given by the crosshatched portion of the marginal cost curve. Fig 08-06.EPS q2 Output PHALL-82241 PINDYCK CHAPTER 08 page 10 of 22 FIGURE 8.7 The Response of a Firm to a Change in Input Price Price, cost (dollars per unit) MC 2 MC 1 \$5 q2 When the marginal cost of production for a firm increases (from MC1 to MC2), the level of output that maximizes profit falls (from q1 to q2). Fig 08-07.EPS q1 Output PHALL-82241 PINDYCK CHAPTER 08 page 11 of 22 FIGURE 8.8 The Short-Run Production of Petroleum Products Cost (dollars per barrel) 27 SMC 26 25 24 23 8000 9000 10,000 11,000 Output (barrels per day) As the refinery shifts from one processing unit to another, the marginal cost of producing petroleum products from crude oil increases sharply at several levels of output. As a result, the output level can be insensitive to some changes in price but very sensitive to others. Fig 08-08.EPS PHALL-82241 PINDYCK CHAPTER 08 page 12 of 22 FIGURE 8.9 Industry Supply in the Short Run MC1 Dollars per unit MC2 MC3 S P3 P2 P1 2 4 5 7 8 10 15 21 The short-run industry supply curve is the summation of the supply curves of the individual firms. Because the third firm has a lower average variable cost curve than the first two firms, the market supply curve S begins at price P1 and follows the marginal cost curve of the third firm MC3 until price equals P2, when there is a kink. For P2 and all prices above it, the industry quantity supplied is the sum of the quantities supplied by each of the three firms. Fig 08-09.EPS Quantity PHALL-82241 PINDYCK CHAPTER 08 page 13 of 22 FIGURE 8.10 The Short-Run World Supply of Copper 1.4 MCCa MCPo Price (dollars per pound) 1.2 MCA 1 0.8 MCPe, MCUS MCCh MCZ MCI MCR 0.6 0.4 0.2 0 0 2000 4000 6000 8000 10,000 Production (thousand metric tons) The supply curve for world copper is obtained by summing the marginal cost curves for each of the major copper-producing countries. The supply curve slopes upward because the marginal cost of production ranges from a low of 65 cents in Russia to a high of \$1.30 in Canada. Fig 08-10.EPS 12,000 PHALL-82241 PINDYCK CHAPTER 08 page 14 of 22 FIGURE 8.11 Producer Surplus for a Firm Price (dollars per unit of output) MC AVC Producer Surplus A B D 0 P C q* Output The producer surplus for a firm is measured by the yellow area below the market price and above the marginal cost curve, between outputs 0 and q*, the profitmaximizing output. Alternatively, it is equal to rectangle ABCD because the sum of all marginal costs up to q* is equal to the variable costs of producing q*. Fig 08-11.EPS PHALL-82241 PINDYCK CHAPTER 08 page 15 of 22 FIGURE 8.12 Producer Surplus for a Market S Price (dollars per unit of output) P* Producer Surplus D 0 Q* The producer surplus for a market is the area below the market price and above the market supply curve, between 0 and output Q*. Fig 08-12.EPS Output PHALL-82241 PINDYCK CHAPTER 08 page 16 of 22 FIGURE 8.13 Output Choice in the Long Run Dollars per unit of output LMC SMC \$40 C D SAC E A P = MR B G \$30 F q1 q2 q3 The firm maximizes its profit by choosing the output at which price equals long-run marginal cost LMC. In the diagram, the firm increases its profit from ABCD to EFGD by increasing its output in the long run. Fig 08-13.EPS LAC Output PHALL-82241 PINDYCK CHAPTER 08 page 17 of 22 FIGURE 8.14 Long-Run Competitive Equilibrium Industry Firm Dollars per unit of output S1 Dollars per unit of output LMC P1 S2 P1 P2 \$40 P2 LAC \$30 D q2 Output (a) Q2 Q1 Output (b) Initially the long-run equilibrium price of a product is \$40 per unit, shown in (b) as the intersection of demand curve D and supply curve S1. In (a) we see that firms earn positive profits because long-run average cost reaches a minimum of \$30 (at q2). Positive profit encourages entry of new firms and causes a shift to the right in the supply curve to S2, as shown in (b). The long-run equilibrium occurs at a price of \$30, as shown in (a), where each firm earns zero profit and there is no incentive to enter or exit the industry. Fig 08-14.EPS PHALL-82241 PINDYCK CHAPTER 08 page 18 of 22 FIGURE 8.15 Firms Earn Zero Profit in Long-Run Equilibrium Ticket price Ticket price LMC Economic Rent LAC LMC LAC \$10 \$7.20 \$7 1.3 Season ticket sales (millions) 1.0 Season ticket sales (millions) (a) (b) In long-run equilibrium, all firms earn zero economic profit. In (a), a baseball team in a moderate-sized city sells enough tickets so that price (\$7) is equal to marginal and average cost. In (b), the demand is greater, so a \$10 price can be charged. The team increases sales to the point at which the average cost of production plus the average economic rent is equal to the ticket price. When the opportunity cost associated with owning the franchise is taken into account, the team earns zero economic profit. Fig 08-15.EPS PHALL-82241 PINDYCK CHAPTER 08 page 19 of 22 FIGURE 8.16 Long-Run Supply in a Constant-Cost Industry Dollars per unit of output Firm MC Industry Dollars per unit of output S1 AC P2 P2 P1 P1 S2 C A B D1 q1 (a) q2 Output Q1 Q2 SL D2 Output (b) In (b), the long-run supply curve in a constant-cost industry is a horizontal line SL. When demand increases, initially causing a price rise (represented by a move from point A to point C), the firm initially increases its output from q1 to q2, as shown in (a). But the entry of new firms causes a shift to the right in industry supply. Because input prices are unaffected by the increased output of the industry, entry occurs until the original price is obtained (at point B in (b). Fig 08-16.EPS PHALL-82241 PINDYCK CHAPTER 08 page 20 of 22 FIGURE 8.17 Long-Run Supply in an Increasing-Cost Industry Dollars per unit of output Firm Dollars per unit of output MC2 MC1 P2 P3 AC2 AC1 Industry SL P2 P3 B P1 P1 A D1 q1 (a) q2 S2 S1 Q1 D2 Q2 Q3 (b) In (b), the long-run supply curve in an increasing-cost industry is an upward-sloping curve SL. When demand increases, initially causing a price rise, the firms increase their output from q1 to q2 in (a). In that case, the entry of new firms causes a shift to the right in supply from S1 to S2. Because input prices increase as a result, the new long-run equilibrium occurs at a higher price than the initial equilibrium. Fig 08-17.EPS PHALL-82241 PINDYCK CHAPTER 08 page 21 of 22 FIGURE 8.18 Effect of an Output Tax on a Competitive Firm’s Output Dollars per unit of output MC2 = MC1 + t MC1 t P1 AVC1 + t AVC1 q2 q1 Output An output tax raises the firm’s marginal cost curve by the amount of the tax. The firm will reduce its output to the point at which the marginal cost plus the tax is equal to the price of the product Fig 08-18.EPS PHALL-82241 PINDYCK CHAPTER 08 page 22 of 22 FIGURE 8.19 Effect of an Output Tax on Industry Output S2 = S1 + t Dollars per unit of output S1 P2 t P1 D Q2 Q1 An output tax placed on all firms in a competitive market shifts the supply curve for the industry upward by the amount of the tax. This shift raises the market price of the product and lowers the total output of the industry. Fig 08-19.EPS Output ...
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## This note was uploaded on 09/28/2011 for the course ECON 105 taught by Professor Prof.eco during the Spring '11 term at Indian School of Business.

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